Central banks face threats to their independence − and that isn’t good news for sound economic stewardship (or battling inflation)

Nearly every country in the world has a central bank – a public institution that manages a country’s currency and its monetary policy^[1]. And these banks have an extraordinary amount of power. By controlling the flow of money and credit in a country, they can affect economic growth, inflation, employment and financial stability – all things that can, if played right, provide politicians with economic boosts around election time, only to saddle the economy with problems further down the line.

That is why, recently, central banks across the globe received significant leeway to set interest rates independently^[2] and free from the electoral wishes of politicians^[3].

In fact, monetary policymaking that is data-driven^[4] and technocratic^[5] – rather than politically motivated – has since the early 1990s been seen as the gold standard^[6] of governance of national finances^[7]. By and large, this arrangement – in which central bankers keep politicians at arm’s length – has achieved its main purpose: Inflation has been^[8] relatively low^[9] and stable^[10] in countries with independent central banks, such as Switzerland or Sweden – certainly until the pandemic and war in Europe began pushing up prices globally.

In comparison, countries such as Lebanon or Egypt, where independence was never extended, or Argentina and Turkey, where it has been curtailed, have experienced more bouts of high inflation^[11].

But despite independence being seen to work, central banks over^[12] the past decade^[13] have come under increased pressure^[14] from politicians. They hope to keep interest rates low^[15] and reap voter gratitude for a humming economy and cheap loans.

Donald Trump is one recent example. While president, Trump criticized^[16] his own choice to head the U.S. Federal Reserve and demanded lower interest rates^[17]. Now, should Trump return to the White House, some of his allies have drawn up plans that would see a reelected Trump sitting in the Fed’s interest rate-setting meetings^[18] or, at the very least, replace current Fed Chair Jerome Powell.

Similarly, the Bank of England’s independence^[19] has been formally put under review^[20]. The British government has also publicly pressured the Bank of England to cut interest rates^[21], presumably to bolster the economy in advance of July’s general election.

As political economists^[22], we are^[23] not surprised to see politicians try to exert influence on central banks. Monetary policy, even with independence, has always been political^[24]. For one thing, central banks remain part of the government bureaucracy, and independence granted to them can always be reversed^[25] – either by changing laws or backtracking on established practices.

Moreover, the reason politicians – especially those facing an election – may want to interfere in monetary policy^[26] is that low interest rates remain a potent, quick method to boost an economy. And while politicians know that there are costs to besieging an independent central bank – financial markets may react negatively^[27], or inflation may flare up^[28] – short-term control of a powerful policy tool can prove irresistible.

Legislating independence

If monetary policy is such a coveted policy tool, how have central banks held off politicians and stayed independent? And is this independence being eroded?

Broadly, central banks are protected by laws^[29] that offer long tenures to their leadership, allow them to focus policy primarily on inflation, and severely limit lending to the rest of the government.

Of course, such legislation cannot anticipate all future contingencies, which may open the door for political interference or for practices that break the law^[30]. And sometimes central bankers are unceremoniously fired^[31].

However, laws do keep politicians in line. For example, even in authoritarian countries, laws protecting central banks from political interference have helped reduce inflation^[32] and restricted central bank lending to the government^[33].

In our own research, we have detailed the ways^[34] that laws^[35] have insulated central banks^[36] from the rest of the government, but also the recent trend of eroding this legal independence^[37].

Politicizing appointees

Around the world, appointments to central bank leadership are political – elected politicians select candidates based on career credentials, political affiliation and, importantly, their dislike or tolerance of inflation.

But lawmakers in different countries exercise different degrees of political control.

A 2023 study^[38] shows that the large majority of central bank leaders – about 70% – are appointed by the head of government alone or with the intervention of other members of the executive branch. This ensures that the preferences of the central bank are closer to the government’s, which can boost the central bank’s legitimacy in democratic countries, but at the risk of permeability to political influence.

Alternatively, appointments can involve the legislative power or even the central bank’s own board. In the U.S., while the president nominates members of the Federal Reserve Board, the Senate can and has rejected unconventional^[39] or incompetent^[40] candidates.

Moreover, even if appointments are political, many central bankers stay in office long after the people who appointed them have been voted out. By the end of 2023,^[41] the most common length of the governors’ appointment is five years, and in 41 countries the legal mandate was six years or longer.

In the 2000s, several countries shortened the tenure of their central banks’ governors to four or five years. Sometimes, this was part of broader restrictions in central bank independence, as was the case in Iceland in 2001, Ghana in 2002 and Romania in 2004.

The low inflation objective

As of 2023^[42], all but six central banks globally had low inflation as their main goal^[43]. Yet many central banks are required by law to try to achieve additional and sometimes conflicting goals^[44], such as financial stability, full employment or support for the government’s policies.

This is the case for 38 central banks that either have the explicit dual mandate of price stability and employment or more complex goals. In Argentina, for example, the central bank’s mandate is to provide “employment and economic development with social equity^[45].”

Conflicting objectives can open central banks to politicization. In the U.S., the Federal Reserve has a dual mandate^[47] of stable prices and maximum sustainable employment. These goals are often complementary^[48], and economists have argued that low inflation is a prerequisite for sustainable high levels of employment.

But in times of overlapping high inflation and high unemployment, like in the late 1970s^[49] or when the COVID-19 crisis was winding down in 2022^[50], the Fed’s dual mandate has become active territory for political wrangling^[51].

Since 2000^[52], at least 23 countries have expanded the focus of their central banks beyond just inflation.

Limits on government lending

The first central banks were created to help secure finance for governments fighting^[53] wars^[54]. But today, limiting lending to governments is at the core of protecting price stability from unsustainable fiscal spending.

History is dotted with the consequences of not doing so. For example, in the 1960s and 1970s, central banks in Latin America printed money to support their governments’ spending goals. But it resulted in massive inflation while not securing growth^[55] or political stability^[56].

Today, limits on lending are strongly associated with lower inflation in the developing world^[57]. And central banks with high levels of independence can reject a government’s financing requests or dictate the terms of loans.

Yet over the past two decades, almost 40 countries have made their central banks less able to limit central government funding^[58]. In the more extreme examples – such as in Belarus, Ecuador or even New Zealand – they have turned the central bank into a potential financier for the government.

Scapegoating central bankers

In recent years, governments have tried to influence central banks by pushing^[59] for lower interest rates^[60], making statements criticizing bank policy^[61] or calling for meetings^[62] with central bank leadership.

At the same time, politicians have blamed the same central bankers for a number of perceived failings: not anticipating economic shocks such as the 2007-09 financial crisis^[63]; exceeding their authority with quantitative easing^[64]; and creating massive inequality^[65] or instability^[66] while trying to save the financial sector.

And since mid-2021, major central banks have struggled to keep inflation low, raising questions^[67] from populist and antidemocratic politicians about the merits of an arm’s-length relationship.

But chipping away at central bank independence is a historically sure way to high inflation.

References

1. ^{^} monetary policy (www.imf.org)
2. ^{^} independently (papers.ssrn.com)
3. ^{^} electoral wishes of politicians (doi.org)
4. ^{^} data-driven (doi.org)
5. ^{^} technocratic (doi.org)
6. ^{^} gold standard (doi.org)
7. ^{^} of governance of national finances (www.sciencedirect.com)
8. ^{^} Inflation has been (doi.org)
9. ^{^} relatively low (doi.org)
10. ^{^} stable (doi.org)
11. ^{^} have experienced more bouts of high inflation (www.imf.org)
12. ^{^} over (www.ft.com)
13. ^{^} the past decade (cepr.org)
14. ^{^} under increased pressure (journals.sagepub.com)
15. ^{^} keep interest rates low (doi.org)
16. ^{^} Trump criticized (onlinelibrary.wiley.com)
17. ^{^} demanded lower interest rates (www.cnbc.com)
18. ^{^} sitting in the Fed’s interest rate-setting meetings (www.wsj.com)
19. ^{^} independence (www.telegraph.co.uk)
20. ^{^} has been formally put under review (www.niesr.ac.uk)
21. ^{^} to cut interest rates (www.telegraph.co.uk)
22. ^{^} political economists (polisci.msu.edu)
23. ^{^} we are (www.essex.ac.uk)
24. ^{^} has always been political (www.cambridge.org)
25. ^{^} can always be reversed (press.princeton.edu)
26. ^{^} may want to interfere in monetary policy (inews.co.uk)
27. ^{^} financial markets may react negatively (doi.org)
28. ^{^} inflation may flare up (doi.org)
29. ^{^} protected by laws (doi.org)
30. ^{^} practices that break the law (doi.org)
31. ^{^} unceremoniously fired (doi.org)
32. ^{^} have helped reduce inflation (doi.org)
33. ^{^} lending to the government (doi.org)
34. ^{^} detailed the ways (doi.org)
35. ^{^} laws (urldefense.com)
36. ^{^} insulated central banks (ssrn.com)
37. ^{^} recent trend of eroding this legal independence (doi.org)
38. ^{^} 2023 study (dx.doi.org)
39. ^{^} unconventional (www.npr.org)
40. ^{^} incompetent (www.politico.com)
41. ^{^} By the end of 2023, (dx.doi.org)
42. ^{^} 2023 (dx.doi.org)
43. ^{^} low inflation as their main goal (urldefense.com)
44. ^{^} sometimes conflicting goals (committees.parliament.uk)
45. ^{^} employment and economic development with social equity (www.bcra.gob.ar)
46. ^{^} AP Photo/Natacha Pisarenko (newsroom.ap.org)
47. ^{^} dual mandate (www.federalreserve.gov)
48. ^{^} often complementary (www.federalreserve.gov)
49. ^{^} late 1970s (theconversation.com)
50. ^{^} winding down in 2022 (www.cnn.com)
51. ^{^} active territory for political wrangling (www.warren.senate.gov)
52. ^{^} Since 2000 (dx.doi.org)
53. ^{^} governments fighting (doi.org)
54. ^{^} wars (doi.org)
55. ^{^} not securing growth (www.sciencedirect.com)
56. ^{^} political stability (www.smithsonianmag.com)
57. ^{^} strongly associated with lower inflation in the developing world (doi.org)
58. ^{^} less able to limit central government funding (dx.doi.org)
59. ^{^} by pushing (inews.co.uk)
60. ^{^} lower interest rates (www.reuters.com)
61. ^{^} criticizing bank policy (www.thenationalnews.com)
62. ^{^} calling for meetings (committees.parliament.uk)
63. ^{^} anticipating economic shocks such as the 2007-09 financial crisis (fortune.com)
64. ^{^} quantitative easing (www.economist.com)
65. ^{^} inequality (www.barnesandnoble.com)
66. ^{^} instability (www.project-syndicate.org)
67. ^{^} raising questions (journals.sagepub.com)